Monthly Archives: October 2008

Martin Wolf is correct when he writes in today’s Financial Times Comment: What the British authorities should try now that “It cannot make sense for US rates to be at 1 per cent and the UK’s at 4.5 per cent” (or the ECB’s rate at 3.75 per cent, for that matter). US interest rates are indeed ridiculously low. The Fed wasted 425 basis points of cuts in the Federal Funds target rate since August 2007 trying to fight a liquidity crunch. And the US recession is only just beginning.

It is not news that the British economy is in recession, as the (quite unreliable) official GDP data indicated yesterday, when a 0.5 percent decline was recorded for the third quarter of 2008. It has been clear since the beginning of the summer of 2008 that there was going to be a broadly based downturn in all the key indicators of aggregate economic activity – output, sales, orders, employment, vacancies etc.. What is new is the unexpected steepening of this decline in activity since August. The economy appears to be falling off a cliff.

It is clear that the major culprit in the recent sharp deterioration of the real economy has been the collapse of the private banking sector in the UK and much of the rest of the north Atlantic region, and the associated virtual disappearance of access to external finance for many households and non-financial enterprises. The lucky ones that can still access banks and capital markets do so at much higher interest rates and against much more stringent collateral and other non-price conditions.

Achim Duebel sent an interesting nugget in the form of this advertisement from Citibank in Germany. Those of you who read German can see the evidence here, where financial engineering meets the New Paradigm (remember the New Paradigm – from the bubble before last?).

Those of you who never learnt to sing “Die Lorelei”, will have to take it on faith that the ad says:

Loans for 3.99%

Deposits for 5.15%.

“But Heinrich, you are making a loss on every euro invested in your bank. ”

Uwe Reinhardt is absolutely correct. The US tax payer is getting a terrible return on the $125bn worth of capital that was injected on his behalf by US Treasury Secretary Paulson into the nine largest US banks. This is surprising to me, because the complete or partial nationalisations of a number of US financial behemoths earlier in the year represented rather better value for money for the tax payer.

The nationalisation of Fannie, Freddie, AIG and pieces of the nine largest US banks (with more to come) was necessary to prevent a complete collapse of the house of cards we used to know as the American financial system.

Unfortunately, Treasury Secretary Hank Paulson’s injection of $125 billion into the nine banks (out of a total capital injection budget provisionally set at $250bn (but bound to rise to probably around twice that amount), carved out of the $700 bn made available (in tranches) by the 2008 Economic Stability Emergency Act, was almost a free gift to these banks. In this it was different from the case of AIG, where the Fed and the Treasury imposed rather tough terms on the shareholders and obtained pretty favourable terms for the US tax payer generally. It was also unlike the case of Fannie and Freddie, where the old shareholders are likely not to recover anything.

Another contribution from my former Princeton colleague, Uwe Reinhardt, now Professor of Political Economy, Economics and Public Affairs at the Woodrow Wilson School and the Department of Economics of Princeton University. Enjoy!

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“In the long run, Americans will always do the right thing-after exploring all other alternatives,” Winston Churchill famously said during Word War II, as Americans still were debating whether or not to enter the European war theater.

One is reminded of Churchill’s dictum on observing a hyperkinetic Treasury Secretary Henry Paulson, in a managerial style that makes former Secretary Defense Secretary Rumsfeld look good by comparison, flail about frantically in search for an effective response to our financial crisis.

Much of contemporary economics does not view capital as dated labour inputs – a view popular with the Austrian School of Mises and Hayek, with clear antecedents in Marx (Karl, not Groucho). Instead it has just two kinds of inputs – instantaneously variable inputs, like labour and raw materials, and fixed inputs like capital goods. Instantaneously variable inputs are hired and immediately produce output which is sold on the market without any lags. Fixed input decisions are taken one year, the capital equipment is installed the next year and starts producing output for which is available for sale the year after that.

This view of the production process means that the cost of capital, interest rates and credit conditions, including credit rationing, don’t have any impact on potential output (supply) over horizons relevant for cyclical stabilisation policy. Their effect on demand, through fixed investment, inventory investment, consumption and net exports, is recognised of course, so the impact of tighter credit conditions, including credit rationing because of a credit crunch, is always assumed to be a lower output gap – demand falls but supply remains unchanged or, equivalently, actual output declines but potential output is unaffected in the short and medium term.

Once we recognise that all production takes time, credit conditions can influence effective supply (effective potential output) even in the short run. Labour is hired this month, produces output next month which is sold at the end of the month after that. Assuming labour is paid no later than the end of the month in which it is performed, the employer has to find enough credit to pay for one month’s worth of wages and one month worth of inventory of finished goods if he is to produce at all, even if the fixed capital is installed and ready to go.

The fiscal and monetary authorities of the North Atlantic region have addressed the financial crisis/paralysis that has afflicted the region since August 2007 using a wide range of measures. Banks and other financial institutions have been nationalised or had minority state participations forced upon them. A wide range of bank liabilities, old and new, have been guaranteed. Central banks are actively performing the roles of lender of last resort and market maker of last resort. Both at the discount window and in repos, central banks now accept an increasingly wide range of collateral from an increasingly wide range of counterparties at an increasing range of maturities.

Still, the unsecured interbank markets remain paralysed. Volumes are minimal and spreads over the OIS rate (the market’s expectation of the average future official policy rate set by the central bank over the relevant maturity) remain at near-record levels. This matters if only because many loans to households and non-financial enterprises are priced off Libor, especially three months-Libor.

Addressing this anomaly is actually very simple, so one wonders why the central banks have danced around this problem for so long without taking the effective remedial action that is well within their authority and competency. All it requires is for the central banks to be willing to lose their virginity by engaging in unsecured interbank lending or, failing that, for the national Treasuries to stand up to their central banks by guaranteeing unsecured interbank lending.

The People’s Bank of Scotland (formerly known as the Royal Bank of Scotland) will soon be 57 percent owned by the British state. A 40 percent ownership stake in Lloyds-TSB-HBOS following their merger is also anticipated. The British state already owned Northern Rock and Bradford & Bingley. The Dutch state owns the Dutch rump of ABN-AMRO and Fortis Nederland. The US government owns 79.9 percent of AIG. Nine major financial US institutions have agreed to participate in both the US Treasury’s ‘voluntary’ capital purchase program and the FDIC’s guarantee program of senior bank debt and assorted deposit liabilities. ‘Voluntary’ is clearly used here in the sense it is used in the armed forces: “I need three volunteers: you, you and you there!” The fact that the US government did not name the nine banks that ‘volunteered’ is crazy - a clear violation of the rule that unless there are very good reasons for the state keeping something secret, and unless it actually will be able to do so, it should put all information in the public domain – and sad.

These partial, majority or complete nationalisations were necessary to stop the complete collapse of the financial sectors in the countries concerned. The reason for this threatened collapse was the utter failure of the old system of soft-touch regulation, self-regulation, toothless supervision and private ownership. There can be no return to the status quo ante.

But the state ownership and control phase should be as short as possible. The state is a dreadful owner and manager of banks and other financial institutions. It can just about manage a central bank – a much simpler job than managing a commercial bank, and one where there is a natural monopoly that makes comparisons of performance difficult. Even so, the job is often not done particularly well .

With a bit of luck, by the time I wake up tomorrow morning, most of the west-European banking system and a fair number of other highly leveraged systemically important institutions like insurance companies, will be in public ownership, with the US not far behind.

That would be the good outcome. The bit of luck required for the favourable outcome to materialise, is that national fiscal authorities are capable of providing credible financial support to their financial sectors. Nationalising the banks need not be fiscal-resource-intensive. At a zero price for bank equity, even an impecunious state can claim ownership of the banks (and other financial institutions) in its jurisdiction. Providing the financial system with the resources required to restore confidence, to permit a resumption of interbank lending and to guarantee an adequate supply of external funds to households and non-financial enterprises is rather more costly.

Please read the following “Action Plan to Combat Crisis”, cribbed from the IMF’s website

Yesterday, October 10, the G-7 met and agreed the following plan of action:

Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure.

Take all necessary steps to unfreeze credit and money markets and ensure that banks and other financial institutions have broad access to liquidity and funding.

Ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and businesses.

Ensure that our respective national deposit insurance and guarantee programs are robust and consistent so that our retail depositors will continue to have confidence in the safety of their deposits.

Take action, where appropriate, to restart the secondary markets for mortgages and other securitized assets. Accurate valuation and transparent disclosure of assets and consistent implementation of high quality accounting standards are necessary.

Now that you have read this, please tell me: where is the beef? Where are the actions? Where are the decisive actions? Where are the internationally coordinated concrete measures and steps to be taken?

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.